To own, or to owe? Today, we’ll find out how debit (to own) and credit (to owe), the two basic pillars of accounting, interact with each other, and how they shape companies’ financial reports from the ground up.
Debit vs. Credit: A Basic Overview
Debit and Credit are the basic units of the double-entry accounting method, which was developed by a Franciscan monk named Luca Pacioli. Pacioli is now called the "Father of Accounting" because the method he came up with is still used today.
The terms debit (DR) and credit (CR) have Latin origins. Debit originated from debitum, which means "what is due," and credit comes from creditum, which means "something given to someone or a loan."
There are a few ideas about what the letters DR and CR stand for when they stand for debit and credit. One theory says that the DR and CR emerge from the Latin words debere and credere, which are the present active forms of the words debitum and creditum. Another idea is that DR stands for "debit record," and CR stands for "credit record."
A "CR" is written on the account when liabilities or shareholders' equity go up. When liabilities go down, we talk about a debit, which is abbreviated as "DR."
Read more about Accounting basics with a complete overview.
Understanding Of Debit vs. Credit Concept
Let's go over the fundamentals of Pacioli's method, also called "double-entry accounting". The first thing to mention is that assets must equal liabilities plus shareholders' equity on a balance sheet or in a ledger.
It's best to take a look at an example to see how this method works. Company XYZ sends Client A an invoice. The company's accountant puts the amount of the invoice as a credit in the revenue section of the balance sheet and as a debit in the accounts receivables section. Both debit (left) and credit (right) sides received an entry, which complies with the double-entry method.
When Client A pays Company XYZ's invoice, the amount is recorded as a credit in the receivables section and a debit in the cash section by the accountant. This method is also called "balancing the books."
When you debit assets, the change must be reflected on a credit account, too. On the other hand, an increase in liabilities (credit) needs to result in a corresponding debit in the appropriate account.
The terms "debit" and "credit" refer to real accounting functions. Based on the type of account, both debit and credit can make the account balance go up or down. Therefore, to appropriately communicate, refrain from using "increase" and "decrease" when talking about changes to accounts.
Use Of Double-Entry Accounting
The double-entry methodology is used by most businesses, even small ones with only one owner. This is because it lets you keep track of each and every business transaction in at least two accounts, giving a more accurate picture of your finances.
The way it works is simple: a debit is put into at least one account, then a credit of the same amount is put into at least one account. Then, the two entries can be utilized to demonstrate how an external transaction is affecting the company’s finances. Ultimately, both the debit and credit side needs to equal one another to result in a book balance.
As we can see, it is always at least two entries in double-entry accounting that enable a company's books to be balanced and show net income, assets, liabilities, and more. There is one exception, though, as the income statement sometimes uses the single-entry method, normally not more than once a year.
With the double-entry method, every time a transaction is recorded, the books are updated, so the balance sheet is always correct. In short, the double-entry method is a great way of keeping track of where the cash comes from and where it goes.
A reminder: with the balance sheet, you can see your assets, liabilities, and owner's equity (net worth) at any given moment, but you only get a timely, static picture of your business's finances.
How To Record Debit And Credit
In your business's general ledger both debits and credits are documented. A general ledger has a full record of all financial transactions that happened over a certain time period.
All changes to the business's assets, liabilities, equity, income, and expenses are recorded as journal entries in the general ledger.
Many bookkeepers and company owners employ accounting software like Wafeq to keep track of debits and credits. That is because when manual ledgers are used to keep track of finances, mistakes are often made that lead to serious financial consequences.